The NSEL problem gets more complicated. It’s now a case of borderline fraud, it seems. Remember the owner of the NSEL (National Spot Exchange), Financial Technologies, lost 65% in marketcap yesterday when news came in that NSEL had stopped trading of nearly all contracts, and will delay payments on current ones by 15 days.
Business Standard talks about how brokers have used the exchange as a multi-leg financing scheme:
The exchange offered two contracts in raw wool. While one, RAWWOOLH2, was settled on a T+2 basis (deliveries and payouts had to be completed two days after the transaction), the other, RAWWOOLH25, was settled on a T+25 basis (deliveries and payouts had to be completed 25 days after the transaction). The contracts could be bought with an initial margin of two per cent.
Officials familiar with the functioning of the exchange said these twin contracts allowed traders to devise pair trade strategies, which allowed them to bet on the commodity without actually holding too much stock.
The price differential between the two contracts amounts to a clear 18-per-cent-a-year return for traders. "The settlement cycle allowed traders to buy the near contract and sell the far one and pocket the difference," said an official. By rolling over these contracts, consistent returns could be made for sustained periods.
Who’s on the other side losing 18% per year? It could literally be anyone that wants credit, which is being offered at 18% a year through this system. That is cheaper than most other sources, especially for sectors like real estate which aren’t getting any more formal credit.
Since a spot market mandates delivery, I actually have to take delivery of all that wool for one contract, and give that wool back for the other. However, if the warehouse is on a wink-nudge basis, I can ask them to offset both entries. This is illegal, but hey, who’s getting hurt here? Until you reach a point where buyers refuse to participate, or where people who realize it’s illegal take action:
What happens to all the wool? The wool is stored in a warehouse in Ludhiana. For storing raw wool, the exchange had mandated four godowns in a village called Seerah, near Ludhiana. The godowns were said to be in the premises of ARK Imports. Ministry of Corporate Affairs records show ARK was incorporated in 2011. Three individuals-Anubhav Aggarwal, Rajni Aggarwal and Kailash Aggarwal (the first letters of the names are ‘ARK’) own the company, with Anubhav holding 98 per cent.
According to the latest stock position provided by National Spot Exchange on July 26, the ARK godowns were holding 11,190.5 tonnes of raw wool. According to data by Wool Industry Export Promotion Council, India’s annual wool production stands at "43-46 million kg", or 43,000-46,000 tonnes. This means the warehouse in the distant Ludhiana village held about a quarter of India’s annual wool production. Not impossible, but unlikely.
To be honest, India imports 75 million kg of raw wool (Source: Textile min), but because we consume so much of it, it’s quite unlikely that we will let 10% of consumption lie in a couple godowns for this transfer drama. More likely is that the entries were “invented” to facilitate the financing scheme.
Why don’t people just borrow directly from other people at 18%? This stupid roundabout scheme is such a pain. But we need that "feeling” of a guaranteed settlement, I guess.
The government hadn’t approved such contracts – a spot exchange is for delivery after all, and has lesser regulation. It seems they’ve been chasing NSEL for a while, with the first show-cause notice a year back. Then in June, they forced the exchange to cut contract settlement periods to 10 days, and eventually, have asked for termination of all trading.
The crisis is only because buyers aren’t willing to roll over their money any further. The people at the selling end – the borrowers, effectively – have been using the money, and can’t return it in any reasonable way quickly. (Think real estate?) And to back this up there are stock entries in godowns. But does that stock actually exist? The answer lies in the wind somewhere, and I’m sure everyone’s got a whiff.
ET has an excellent FAQ on this.
Impact: If there are dummy stocks, then this snowballs into outright fraud. The guilty must go to jail, even if they are big and powerful people. This is not “harmless” – it is criminal. If they don’t put people in jail, there will not be any confidence in the financial system at all, and we can cry ourselves hoarse about people not investing, but the problem is the lack of enforcement.
Secondly, if the drama is true, FT is in major trouble. It may find a legal way to wiggle out of some of the settlement, but this business is about trust – if it’s known that FT let defaults happen, no broker will want to trust them any longer….and that’s pretty much the end of the game.
Thirdly, the collateral damage is going to be big. There are PMS schemes that told investors they could get 15% returns through this. There are banks that somehow have exposure. There are NBFCs that have been in on the game. The impact will be known only later, but it involves a lot of well known names in the financial sector.
Finally, the need for proper regulation exists. Spot exchanges don’t have regulators, and we actually can enhance the current lot (SEBI and FMC) to work with them. Any leveraged scheme has to have adequate provisioning cover, risk control and strong enforcement – so even the SEBIs, FMCs and RBIs need to up their ante. This is not the first, and this will not be the last instance of ponzi borrowing.